12/25/2008 @ 1:40PM

Charitable Annuity Safetynet

If you are retired and living off your capital, you have two things to worry about. One is that your portfolio might crash. The other is that you might live too long and run out of money to buy groceries.

Consider a charitable gift annuity. It will pay a bit less than similar products from private insurers, but if you choose well you’ll get an immediate tax deduction, a decent return, zero volatility and the psychic pleasure of supporting a worthy cause. These things made a fair amount of sense even when interest rates were somewhat high. Now that long-term Treasurys are yielding a tiny 3%, they make a whole lot of sense for risk-averse retirees.

You plunk down a lump sum and the charity promises you a lifetime of fixed payments. Buyers can select an income stream that lasts as long as they do, or, for a reduced payment, a second-to-die option that keeps paying until both spouses pass on.

Simplifying matters, almost all nonprofits use the same payout rates, set by the American Council on Gift Annuities and aimed at leaving the charity, eventually, with half the cash sent in by the annuity purchasers. (The discounted present value of what you’re giving away, however, is a good deal less than half of your annuity purchase price.) All else being equal, the smart move is to focus on well-known nonprofits with lots of assets. “I’d select one with a $5 gazillion endowment,” says Vaughn Henry, an estate planner in Springfield, Ill.

We recently got a quote for an imaginary couple, both 70, willing to hand $100,000 in cash to Atlanta’s Emory University, whose $23 million in annuities payable is backed by a hefty $7 billion endowment. The Internal Revenue Service would grant the couple a charitable deduction of $28,128 from this year’s taxes. If they are in a 40% combined state and federal bracket, their deduction is worth $11,251, making the effective cost of the investment $88,749. With the second-to-die option, which most couples select, the payout would be $5,600 a year, or a 6.3% return. (A one-life annuity would pay $6,100.)

Since a portion of the couple’s $5,600 annual income is a return of capital, they would receive $3,506 tax free and pay ordinary income taxes on only $2,094. Figure in taxes at 40% and they’re getting an aftertax $4,762, or 5.4% of their net investment. After 20.5 years the return of capital deduction is exhausted and the aftertax return drops to $3,360.

How does this compare with private-sector annuities? For our 70-year-old couple, low-cost Vanguard Group quotes annual payments on a second-to-die annuity of $7,578 per $88,749 invested. Figure in the return-of-capital deduction, and they’re getting $6,278 aftertax. That’s a 7.1% return.

There is some risk in the charitable annuity: The college or charity with your money might go bust. But private annuities aren’t sure things, either. You might get goose bumps on discovering that, while the assets behind Vanguard’s annuities are safely walled off, the annuity policies are issued and guaranteed by financially ailing
American International Group
.

Annuities remain a small part of overall charitable giving, with perhaps $20 billion in gift annuities outstanding and another $1 billion added annually, figures Seattle planned giving expert Frank Minton. Competition has prompted a handful of charities to offer above-average payouts. Harvard, with the country’s largest college endowment at $29 billion (as of Oct. 31), offered our couple a $5,800 annual payout. The Humane Society of the United States (endowment: $150 million) beat that by $50 a year. California’s elite Pomona College, with $59 million in annuities payable and a $1.5 billion endowment, offered 7%. (With that payout your charitable deduction falls to $10,159.) Yale University is the cheapskate, offering our couple 4%.

A number of nonprofits, including World Vision and the Leukemia & Lymphoma Society, troll for annuity clients by sponsoring
Google
links. A request for a quote from American Bible Society, which recently suffered a scandal and financial problems, elicited an e-mail proposal and five follow-up calls. Other Google ads for what looked like gift annuities were planted by insurance agents flogging costly annuities.

Gift annuities are regulated by the states. Although protections vary widely, defaults and fraud are rare among well- established charities. Many states, including Nebraska, do not require reinsurance or segregation of annuity accounts. Even so, the National Arbor Day Foundation of Lincoln takes a conservative approach, segregating contributions and not withdrawing a dime for its own benefit until after the annuitant dies.

Two big downsides to gift annuities: Payouts are not indexed to inflation, and unlike some commercial products, they do not offer options to return a portion of capital to heirs if a customer dies shortly after annuitization. If you feel more charitable about your heirs than about your alma mater, you’d probably be better off buying municipal bonds.

Don’t pay a broker to find a gift annuity. Instead, type “gift annuity” of a charity that interests you into the Web site’s search box. If all looks good, review its financial statements or tax returns to make sure its endowment amply covers its annuity obligations.